Emerging Markets Outlook Q1 2026 Strengthening fundamentals, still underowned

Emerging market (EM) equities are starting 2026 with renewed momentum, supported by a combination of macroeconomic tailwinds, some evidence of structural profitability improvements, and strengthening investor sentiment.

Emerging market equities’ robust performance in 2025

EM investors faced a wide range of challenges at the start of 2025, including:

• Tariff shocks: The Trump administration’s policy on tariffs was set to negatively affect EM economies.
• Chinese consumer declines: Chinese growth was looking “iffy”, and earnings growth, while steady, wasn’t particularly spectacular.

But these hurdles were overshadowed by three more powerful shifts:

• Pressure on the US dollar: Some cracks in the “King Dollar” thesis, or that the US dollar will remain the world’s dominant currency, created an opening for investors to look to hedge. Investors who had been heavily allocated to US assets for several years had reason to reassess that positioning.
• AI business investment: The DeepSeek news in January may not have been as much of a game changer as some had argued, but it surely reminded investors that China is an extremely important player in the AI revolution (not to forget about Korea and Taiwan).
• Strong EM earnings: Corporate earnings per share (EPS) was surprisingly solid, with 16% growth in 2025 (preliminary). More than 20% growth is expected for 2026, per FactSet.¹

Overall, EM equities had a fantastic 2025, posting a gain of 33.6% compared to 17% for the S&P 500 and 21% for the MSCI World index—EM’s best year versus developed markets since 2017.² The asset class has started off strong in 2026 too, rising 5% year-to-date.³

Key factors supporting the case for EM equities now

Given that EM currencies appreciated strongly against the US dollar in 2025, weakening in the dollar this year could help boost EM economies. Still-light investor positioning in EM equities globally, as well as the potential for EM profits to catch up to developed market profits, adds to the asset class’ potential performance momentum into 2026.

“Sell America” sentiment and a still-pricey US dollar set the stage

Some market participants have posited that the US administration may pivot from its unpredictable approach to US foreign policy, and instead focus on domestic issues in the run-up to the midterm elections. But the events of early January suggest this may have been a false hope.

In early 2026, we think reallocations away from the US are likely—especially as the US dollar remains quite expensive (in real terms) relative to history. Since the end of the gold standard, the US dollar has only been this strong a few times.⁴ Investors have so far mostly been picking up dollar hedges, versus selling dollar assets (Figure 1). However, there is risk here, and it will likely favor non-US assets for some time.

Profitability convergence?

An enduring theme keeping investors on the sidelines of EM stocks is that they have been under-earning their US counterparts for some time.

The inertia of the EM underweight proved to be a solid trade through last year, but investors still appear to view EM equities as a trading dynamic. On the flip side, we are starting to see some profit convergence—particularly in big tech names—that is getting investors’ attention. This is occurring as valuations remain high for US assets and Europe remains in the crosshairs of geopolitical pressure.

If there is one trend investors will want to keep an eye on in 2026, we believe it is the emerging and developed market return on equity (ROE) convergence story. Consensus expects 21% EPS growth in EM equities this year—substantially higher than the US and developed markets at 15% and 13%, respectively.⁵ The more EM can out-earn World ex US and inch closer to World (Figure 2), the stronger the long-term investment case becomes. And, we could see EM equities enter a new cycle of sustained strength.

Investors still underweight EM equities

Despite last year’s momentum, most investors did not participate in the 2025 EM equities rally. Aggregate positioning data from State Street Global Markets suggests global investors are still underweight EM.⁶  They are less underweight than they were (there were especially large moves in Chinese exposure). But, broadly speaking, most investors did not benefit from EM’s strong performance last year.

Moving forward, there is still potential for new money to enter the asset class, and we expect investors to at least neutralize EM postioning (Figure 3). In 2025, EM equity funds saw the strongest inflows since the post-Covid recovery—roughly $30 billion—but looking beneath the surface, the divergence was clear.⁷  While optimism was most prominent among ETF buyers, as EM ETFs saw inflows of nearly $88 billion, non-ETFs saw outflows of $58 billion.⁸
 

From improving EM fundamentals to value in balance

Valuations remain one of the strongest arguments in favor of EM equities. Even after a strong rally in 2025, EM equities continue to trade at a meaningful discount to developed markets. While this valuation gap has narrowed somewhat, it remains wide enough to attract global investors seeking diversification and growth at more reasonable prices.

At the same time, investors should consider:

• Valuation dispersion argues for ballast: We continue to focus on the wide valuation spread within EM equities. The difference between the most expensive stocks and those in the middle are at near-record levels. And while dispersion is not unique to EM, it makes sense for investors to keep some ballast in their exposures.
• Growth matters and so does price. We have a great deal of respect for many high-growth EM companies. However, strong growth doesn’t eliminate valuation risk. Maintaining discipline around what investors are willing to pay for that growth remains essential, especially after 2025’s strong performance.
• Quality still has a role. Value does not mean low quality. Investors may benefit from retaining quality value as a stabilizing holding within EM portfolios. In general, investors could benefit from pursuing growth, but continuing to be mindful of value (Figures 4 and 5).
  

Translating balance into positioning

Our emphasis on balance is reflected in how we are currently positioned across regions and sectors.

Regional positioning: Valuation, momentum, and flows

We continue to favor Chinese stocks, largely funded by underweights in India. Over the medium term, India is one of the most compelling structural investment stories. Near term, however, the ingredients are not aligned for this year. China offers a more attractive combination of relative value, momentum, and larger underweights to attract capital—alongside a more resilient currency backdrop. We are neutral to slightly underweight EMEA. After strong gains in smaller markets, the set up into 2026 may be tricky. Lower oil prices may eventually create attractive entry points in some segments of Middle East markets, but for now we remain patient.

Sector positioning: Staying selective

Within Technology, we favor Korea and Taiwan, where fundamentals remain supportive. More broadly, we prefer IT, financials, and communication services funded by underweights in healthcare, utilities, and energy. We also prefer large caps over small caps this year.